Ardo HanssonEesti Pank

Convergence Dynamics in the EU after the Economic Crisis25 April 2014

Topics

A. The risks from growth differentials for sustainable convergence

B. Which structural reforms should receive more attention if sustainable growth is to be ensured?

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A. The risks from growth differentials for sustainable convergence: background

The euro area, like the EU, has relatively high variation in income and productivity levels.

This helps to explain the significant differences in economic growth between ‘new’ (poorer) and ‘old’ (richer) euro area member countries.

Although convergence of income and productivity levels is a positive development that reduces the differences between member countries and thereby makes the conduct of monetary policy easier, there are potential risks to this process. During simultaneous real and nominal convergence there is a risk of several ‘amplification channels’ being activated that might lead macroeconomic imbalances and vulnerabilities to arise.

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1. Self-fulfilling expectations;

2. Collateral and wealth effects;

3. The real interest rate channel.

All three ‘amplification’ channels played a role in the Baltic states throughout the boom in 2004-07 and the recession of 2008-09.

The relevance of the episode for the future is underscored by the fact that all of the three countries had credible fixed exchange rate regimes and operated under macroeconomic conditions not unlike those in the euro area.

The risks from growth differentials for sustainable convergence: amplification channels

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A cyclical peak is defined as being when the quarterly GDP is higher than in the two preceding quarters and higher than in the next two quarters. A cyclical trough is defined as being when the quarterly GDP is lower than in the two preceding quarters and lower than in the next two quarters.Sample: 23 advanced economies and 18 emerging market economiesData: 1960 Q1 – 2012 Q2, seasonally adjusted, constant prices.Source: IMF IFS databaseVariables: (1) GDP

(2) net foreign capital inflows (3) real interest rates (4) CPI-based REER

Altogether 188 episodes of recessionWe concentrate on developments four years before and three years after the peak in output level.

The cyclical pattern in the Baltic states in international comparison: methodology and data

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A comparison of the cyclical pattern in 2004-2011 in the Baltic states with previous cycles in other countries: real GDP

A. GDP dynamics during the four years before the cyclical peaks (t-15=100)

B. GDP dynamics during the three years after the cyclical peaks (t0=100)

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A comparison of the cyclical pattern in 2004-2011 in the Baltic states with previous cycles in other countries: net foreign capital inflows

A. Net foreign capital inflows during the four years before the cyclical peaks (% of GDP)

B. Net foreign capital inflows during the three years after the cyclical peaks (% of GDP)

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A comparison of the cyclical pattern in 2004-2011 in the Baltic states with previous cycles in other countries: real interest rates

A. Real interest rates during the four years before the cyclical peaks (%)

B. Real interest rates during the three years after the cyclical peaks (%)

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The risks from growth differentials for sustainable convergence: summary

• Comparable cyclical swings to those of GDP, foreign capital inflows and real interest rates were also evident in real estate and stock prices and in loan volumes.

• Overall, previous experience has clearly demonstrated that during speedy convergence, strong amplification channels create the risk of macroeconomic imbalances.

• To an extent, similar developments were visible in several of the euro area countries that ran into substantial difficulties.

• Although the re-run of the boom/recession cycle in the Baltic states is less strong than before, it is important to keep in mind that strong convergence in a currency union requires a response at a national level to address the potential rise of macroeconomic imbalances.

• As a result, national policies like fiscal and macro-prudential policies should be used early and decisively.

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B. Which structural reforms should receive more attention if sustainable growth is to be ensured?

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Source: World Economic Forum, Global Competitiveness Report

In a country by country analysis, the scores of the countries by the 12 ‘pillars’ are mostly related to the overall productivity level of a given country (and not the previous economic growth).

However, there are also two pillars out of 12, which are positively related to the economic growth between 2001-2013.

These pillars are:1. Macroeconomic environment;2. Labour market efficiency;

EU-28 rank EA-18 rankout of all 148 countries out of all 148 countries

Global Competitiveness Index (total) 40 37

Basic requirements (21.7%) 39 34Institutions 46 44Infrastructure 31 27Macroeconomic environment 61 72Health and primary education 27 21

Efficiency enhancers (50.9%) 35 33Higher education and training 26 25Goods market efficiency 43 41Labour market efficiency 56 61Financial market development 53 61Technological readiness 24 24Market size 48 56

Innovation and sophistication (28.3%) 38 33Business sophistication 39 35Innovation 36 35

Which structural reforms should receive more attention if sustainable growth is to be ensured?

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Source: World Economic Forum, Global Competitiveness Report

Ranking in EU-28Macroeconomic environment

Labour market effi ciency

1 Luxembourg Denmark2 Sweden United Kingdom3 Finland Ireland4 Estonia Estonia…25 Hungary Spain26 Italy Portugal27 Portugal Greece28 Greece Italy

Which structural reforms should receive more attention if sustainable growth is to be ensured?

1. Strengthening of the macroeconomic environment;

2. An increase in labour market efficiency;

These are also the areas where both the euro area and EU had the lowest ranking in global comparison in 2013.

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